One situation I often encounter with small businesses is that sometimes they don’t always document the transactions they enter into with their owners and other related parties. For instance, let’s say that two owners of a corporation decide that their corporation needs more funding. However, they don’t want to invest more equity into the business. They are willing to extend a loan to their company and expect to get paid back over the next few years with interest. Here’s how that should work (assuming this company is a C Corporation):
The corporation would make payments of principal and interest back to the shareholders. The corporation would be able to deduct the interest as an expense. The owners would not need to pay taxes on the principal but would pay taxes on the interest. There are no double taxation issues because the interest expense is deducible to the corporation.
Unfortunately, small business owners often don’t take the time to properly document transactions like this. They may enter it into their accounting books, but the don’t prepare any loan documents, nor do they prepare any board resolution authorizing the company to enter into the loan. After all, from the owners’ perspective, this is a loan to “themselves” and it seems like a waste of time and money to have official documents prepared. This can cause a couple of problems down the road.
First, if the IRS audits the company, they will ask to see the loan documents and resolutions authorizing the transaction. When the owners can’t produce them, the IRS can (and often does) recharacterize the transaction as a dividend. As a consequence, the loan interest is no longer deductible. Therefore the owners will pay double taxation on the interest. In addition, depending on the capital structure, the principal payments could also be deemed a taxable distribution, thus causing the owners to pay income taxes on the return of principal (which never would have happened had the transaction been properly documented as a loan).
Another area where this can cause problems is when the owners decide to sell their business or sell an interest in it to outsiders. Failing to properly document earlier transactions can cause problems in due diligence, which any sophisticated purchaser or investor would perform on a business he intends to acquire. The process of cleaning the mess up could be expensive (far more expensive than simply having documents prepared from the outset.)
A loan is just one example of the type of transaction that should be documented even when made between related parties. Another example is leases. Many business owners lease their own property to their business. But if they don’t prepare a written lease, the rent payments could be recharacterized as dividends or distributions. Here’s a couple of other examples: employment agreements, service agreements, purchases and sales of assets, and sale-leaseback transactions. All of these transactions between a business and its owners should have some level of legal documentation.
© 2011 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.